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Why the IRS Audits Tax Returns?

The Examination Division of the Internal Revenue Service is responsible for auditing federal tax returns to determine if income, expenses, and credits are reported accurately. Although the IRS accepts most tax returns when filed, there are circumstances that warrant an audit. Within this context, the IRS is motivated to evaluate those areas of a tax return that fail to comply with current policies and provisions. In general, the IRS motivation behind auditing taxpayer returns falls under multiple categories.

First, the IRS is motivated to audit returns for the purpose of finding unreported income. In conducting both random and strategic audits, the “IRS has taken a renewed interest in finding unreported income” (Kane, p. 4). The IRS examines a taxpayer’s lifestyle to determine if income has been reported properly. For example, agents may use Form 4822[1] to determine how much a taxpayer spends annually for the purpose of comparing amounts to what the taxpayer reports on the return. If the agent is compelled to prepare a “cash T,” which represents a simple source and application of funds analysis, then the agent will pursue options that include questioning the taxpayer and indirect methods.

Second, the IRS Examination Division is motivated to audit returns to ensure customer service goals are met; these goals are specific to applying the provisions of the Taxpayer Act. In 1998, the Taxpayer Bill of Rights III[2] mandated changes in the type of customer service solutions the IRS must provide to both taxpayers and audited taxpayers. The IRS is motivated to ensure that the Taxpayer Act is implemented correctly and efficiently.

Third, the IRS Examination Division is motivated to audit returns of businesses in specific industries. For example, when it comes to conducting audits for a particular industry, the IRS gathers information about an industry for the purpose of creating an average profile. “Actual returns will then be compared against the profile to help find compliance problems” (Kane, p. 5, 5/21/2013). The IRS then issues guidelines, between 40 and 90 to date. In Bob Kane’s[3] article titled “What is the IRS Examination Division Up To Today (October 19, 1998),” he suggests that “[a]udit coverage has dropped off considerably from the mid-1970s when it was at the 2.59% level overall, to the 1.38% level of today” (Kane, p.1, 5/21/2013). However, the IRS is still motivated to evaluate particular industries. “The construction and fishing industries are two constant areas of scrutiny by the local IRS office. The IRS locally also has been focusing on mobile cart vendors, Laundromats, car dealers, bed and breakfasts, and businesses involved with . . . freight forwarding, import/export businesses, and storage and transportation businesses” (Kane, p. 4, 5/21/2013).

Lastly, the IRS is concerned about an additional area, namely employee/independent contractor audits because it represents a huge revenue loss. The IRS cannot collect payroll taxes from independent contractors. In addition, because there are issues with audits in this area, agents have received considerable training specific to worker misclassification. For example, the IRS unveiled the Classification Settlement Program, giving employers the option of settling cases where they have misclassified workers at reduced assessments. Tax attorney, Bob Kane, comments on this, stating, “To obtain the reduced assessments, the taxpayer must agree to treat the workers as employees in the future. The assessments vary between 25 and 100 percent of the tax liability for one year, depending upon the taxpayer’s level of compliance with the Section 530[4] requirements” (Kane, p. 6, 5/21/2013). The Small Business Job Protection Act (1996) modified Section 530, thereby changing the worker classification; the changes shift the burden of proof to the IRS “if the taxpayer establishes prima facie a reasonable basis for having not treated workers as employees” (Kane, p. 6, 5/21/2013). Employee training (IRS) within this area will increase the number of compliance incidences.

Motivations around IRS audits tend to reveal much about the purpose of each type of audit and the overall strategy of the Internal Revenue Service. By learning more about the motivations behind an IRS audit, taxpayers can hopefully avoid facing the scrutiny of the IRS. If you would like to know more about IRS audits, please read my other writings, available at: http://www.sambrotman.com/category/irs-audits-and-examination/

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[1] Form 4822, Statement of Annual Personal and Family Expenses

[2] The 1998 Tax Act is formally referred to as the Internal Revenue Service Restructuring and Reform Act of 1998. It is known as the Taxpayer Bill of Rights III (Pub.L. 105-206, 112 Stat. 685, enacted July 22, 1998).

[3] Robert M. Kane, Jr. is a civil tax attorney with LeSourd & Patten, P.S. Attorneys at Law. Kane handles tax dispute resolution, tax litigation, and administrative appeals. Kane graduated with a J.D. from Gonzaga University School of Law and with an LLM from New York University. For more information or to view his profile, visit: http://www.lesourd.com/attorneys/robert_kane.

[4] Section 530 of the Revenue Act of 1978

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